Bitcoins explained: A viable future currency, or an accident waiting to happen?

'Bitcoins' have graduated from the murky world of hackers and online drug deals to the finance pages thanks to a price bubble and crash this week. But what are they?

Bitcoins are a digital currency that has no state or authority backing it, no central bank or any institutional control. There are no physical Bitcoins.

Presenting itself as a libertarian monetary experiment that admittedly might not work, Bitcoin's aims are simple, to become a universal global online currency that bypasses banks and interference from regulators and nation states.

Tender subject: Bitcoins are attracting speculative investors - but come with no official backing.

Created by hackers in 2008 (see box below), Bitcoins gained notoriety two years ago when stories emerged of the currency being used to buy drugs online anonymously.

It was back in the headlines this week following a dramatic swing in its value. After being first available for just a few US cents, Bitcoins have risen in value and spent most of 2012 being worth between $5 and $10 each.

Then came a rapid climb that saw them soar to $80 last month and then a whopping $147 this week before crashing to $108.

Driving this rise is thought to have been savers in beleaguered Cyprus - many of whom are wealthy Russians - seeking to take their savings out of the country as authorities thrashed out details of a tax on deposits. They saw Bitcoins as a better home for their cash.

The correction that then followed came after reports that an online account service for Bitcoins, Instawallet, was hacked.

Alistair Cotton, a senior analyst at Currencies Direct said: 'The rise of Bitcoin as a viable alternative to conventional currencies depends on users subjective assessment of its value.

'Aside from its day-to-day uses, part of the appeal of Bitcoin is the absence of government control and the anonymity using the currency provides.

'In an era of ultra low interest rates and investors seeking safety, diversification away from traditional assets and into exotics is very fashionable.'

Mr Cotton said that the underlying idea behind Bitcoin was a good one. He added: 'Innovative systems allowing increasing trade should be good for economic growth in the long run.

'However we are currently in the very early, disruptive stage of technological development of digital currencies, meaning a lot of trial and error will need to take place and fortunes will be made and lost before anything remotely feasible starts to challenge conventional government backed money.'

BITCOINS: WHAT YOU NEED TO KNOW

What is it?

The Bitcoin operates as a two way currency which can be exchanged for dollars and vice versa.

The notion behind it is to facilitate
cheap, anonymous transactions policed by its community of users and is
built around trust rather than relying on institutions like governments
or banks.

Bitcoin's status as a digital currency
is debatable, it is entirely a digital product but is not regulated and
it has a limit of 21million, which is predicted to last until 2140. The finite nature of Bitcoins means it performs more like a commodity, such as gold.

Where did it come from?

Bitcoin first emerged in 2008 and
launched as a network in 2009. It was created by an obscure hacker whose
identity is a mystery but is known as Satoshi Nakamoto, which is thought
to be a pseudonym for the person or group who created it.

How does it work?

Each Bitcoin is a piece of computer code that has been generated through very slow computer processing, also known as 'mining'.

Users choose a virtual wallet from one
of the various providers which enables them to receive, give and trade
coins from other users.

Bitcoin's can be bought from specialist online currency exchanges and online marketplaces such as ebay.

Where can I spend it?

The idea is that Bitcoins can be used for respectable online purchases but it is not that simple.

It is not clear to the average
internet user where to spend Bitcoins. If you google 'where to spend
Bitcoins' all that appears is a long list of retailers,
the majority containing 'Bitcoin' in their name, offering everything
from website domains to electronics to MP3 downloads.

Can anyone use it?

According to Currencies Direct any person can download a Bitcoin wallet and begin buying and selling Bitcoins.

Is it safe?

Considered by its critics as more of a
risky investment than a genuinely useful online currency, Bitcoin has
had some questionable moments in its development that caused wild fluctuations in its value.

Creators admitted one major security
scare in August 2010 where a vulnerability was exploited and a
user created billions of coins before the transaction was noted and
erased from the log.

Advocats of Bitcoin celebrate the lack
of regulation that comes with the scheme, yet this lack of
institutional control means there is no guarantee or security of users
money.

As Bitcoin facilitates a cheap and
anonymous trade with no regulation it has dogged by reports that it is used by money launderers and criminals.